Traditional security issuance vs. blockchain-based tokenization

The issuance of securities such as real estate funds is an essential but complicated part of the financial system. The major reason for this complexity lies in the amount of involved (centralized) stakeholders. Tokenization, the issuance of real-world assets using blockchains, not only removes a lot of that complexity but also enables the issuance of completely new asset classes.

This post contrast the problems of traditional security issuance with advantages of a blockchain-based tokenization.

Issues and problems in the issuance and trading of (crypto) securities

Issues and problems in the issuance and trading of (crypto) securities (1/2)Issues and problems in the issuance and trading of (crypto) securities (2/2)

Each of these points is explained in more detail below.

Involvement of multiple stakeholders and intermediaries

These multiple stakeholders bring with them a range of efficiency problems:

Ongoing reconciliation: Because every stakeholder stores transactions independently, data inconsistencies, which must be corrected through ongoing reconciliations, are likely.

Slow settlements and issuance process in general: Because every stakeholder validates transactions independently, settlement times are long. Furthermore, the more stakeholders are involved, the longer the issuance process in general.

High fees: The more stakeholders are involved, the more fees investors incur. In sum, most fees for the issuance and trading of (crypto) securities are too high.

Partial system uptime: The more stakeholders are involved the less likely they are to be available at the same time, And because the outage of one stakeholder affects the whole system, constant up-times are unlikely.

There are also second-order consequences caused by these efficiency problems, especially in the context of high fees, minimum investment volumes, and intransparent fee structures.

High fees, minimum investment volumes (caused by high fees), and intransparent fee structures caused by the involvement of multiple stakeholders

These second-order consequences center around:

Decreased ROI: High fees lower ROI

Excluding small investors from investing: High costs lead to high minimum investment volumes which in turn excludes many small investors from investing

Intransparent fee structures make it difficult to understand the actions of the fund managers

Issuance of less costly investment products: High fees prevent the issuance of less costly investment products because fees would not stand in proportion to investment value

Other problematic attitudes of the current approach to security issuance centers around the existence of centralized systems, slow settlement times, and human-made contracts.

Centralized systems, slow settlement times, and human-made contracts

The major issues arising from centralized systems, slow settlement times, and human-made contracts are high counterparty risks and potential for litigations.

Increased counterparty risk through many (centralized) stakeholders and human-made contracts: The more (centralized) stakeholders are involved the longer it takes to for a transaction to be confirmed and thus increases counterparty risk. Moreover, because humans stand behind contracts, the fulfillment of these contracts (e.g dividend payouts) depends on these people’s goodwill and thus increases counterparty risk.

Human-made contracts bear the potential for litigations: Similarly to above, the humans that agreed upon contract can simply ignore their obligations. This often leads to time-consuming litigations.

Furthermore problematic is the fact that the issuance process itself is a very complex and manual issuance process.

Complex and manual issuance process

The result of a complex and manual issuance process shows itself in slow/incomplete audits, a slow issuance process in general, and high fees.

Slow and incomplete audits: Because there are multiple (manual) steps involved in the issuance of securities, auditing them is difficult.

High fees: The less automation and the higher human involvement, the higher are involved fees.

Related to the manual issuance process, are the human-made contracts which introduce a lot of opaqueness.

Human-made contracts and intransparent fund manager activities

Because of their secretiveness fund managers can ignore contracts without repercussions: Because investors have little insight into fund managers’ activities, managers can easily ignore contractual agreements regarding use of funds without any repercussions. As a consequence, the only thing remaining for investors is to trust that fund managers will spend the money as they are supposed to.

Next to fund managers, two other powerful entities are banks and governments.

Dependency on banks and governmental restrictions

The dependency on banks and governments leads to an exclusion of unbanked people and to trading limitations and different tax advantages.

Unbanked people are excluded from the investment market: Unbanked who do not have access to banks are excluded from many investment possibilities.

Trading limitations and different tax advantages: Not all securities have the same global availability and thus people from some countries might not have access to certain stock, for instance. Furthermore, globally differing tax structure treat investors differently worldwide.

Finally, the current process for issuing securities prevents the creation of a well-diversified crypto portfolio.

Limited availability of investment products

In the non-crypto world diversified portfolios (e.g. stocks, bonds, and real estate funds) can be constructed to diversify risks. Such risk management is impossible in the crypto world due to lack of investment products (the primarily available asset classes are regular cryptocurrencies and stablecoins)

Tokenization solves these issues.

Contrasting the problems of traditional security issuance with advantages of a blockchain-based tokenization

Tokenization to reduce complexity and enable the issuance of new assets

Tokenization refers to the issuance of asset-backed tokens (also referred to as Proof-of-Asset or PoA tokens) using blockchains. These PoA tokens are digital representations of real-world assets, are thus backed by them and derive their value from them. Asset-backed tokens can, of course, be traded digitally. PoA tokens combat the above-mentioned as following.

As expected, most of it centers around the removal of middlemen and the creation of one unifying record for transactions.

Involvement of multiple stakeholders and intermediaries

By relying on less (centralized) stakeholders, tokenization removes reconciliations, increases settlements and the issuance process in general, lowers fees, and increases the likelihood of constant uptimes.

No reconciliations, faster settlements and faster issuance process in general: Because there is only one record for transactions, transactions are stored and validated only once. This omission of redundancies lowers settlement times and makes reconciliations redundant. Furthermore, the fewer stakeholders are involved, the faster the issuance process in general.

Lower fees: Furthermore, fewer stakeholders equals lower fees.

Less complex systems increase the likelihood of constant uptimes: The fewer systems exist that can fail, the lower the likelihood of outages. Thus, the likelihood of constant up-times is increased.

Similarly, this leads to a removal of the above-mentioned second-order consequences in regards to high fees, minimum investment volumes, and intransparent fee structures.

High fees, minimum investment volumes (caused by high fees), and intransparent fee structures caused by the involvement of multiple stakeholders

By relying on less (centralized) stakeholders, tokenization enables higher ROIs, clearer fee structures, opens the market to more participants, and the issuance of new asset classes.

Increased ROI: Lower fees increase ROI

Lower fees open to market to investors with smaller investment volumes: Smaller fees result in smaller minimum investment volumes. These, in turn, enable more investors to participate.

Clearer fee structures: Fewer stakeholders and an open system remove much opaqueness around fee structures

Lower costs enable issuance of new asset classes: Because lower fees would bring the investment/fee relation into more reasonable proportions, a whole range of inexpensive or simple assets can be traded. Examples include movies, collectibles, and apps. This post shows companies tokenizing these asset classes and many others.More on startups tokenization the real-world here.

Decreased likelihood of counterparty risks due to faster settlement times, higher automation, and less centralized stakeholders: Because there is only one transaction record where transactions are stored/validated and because the system has less centralized stakeholders, the likelihood of counterparty risk is decreased. Moreover, higher automation, for instance, by replacing human-made contracts with smart contracts that automatically execute contracts (e.g dividend payouts), add to a more counterparty risk-free system.

Smart contracts decrease the potential for litigations: Because smart contracts automatically execute contractual agreements, participants cannot escape their agreements and there is little room for ambiguity or discussion. Thus, litigations are less likely to occur.

Similarly, blockchain-based systems can improve the (financial) efficiency of trading/issuance.

Complex and manual issuance process

Quicker/fullers audits and issuance: In blockchain-based trading/issuance systems, all process are digitally stored and have a high level of automation (e.g. through smart contracts). This allows for a complete audit trail and faster issuance.

Lower fees through automation: Furthermore, the higher the automation (e.g. through smart contracts) the lower the fees.

Smart contracts also help to prevent fund misuse.

Human-made contracts and intransparent fund manager activities

As smart contracts automatically execute contracts, issues related to the misuse of funds are avoided and all investment transactions done by fund managers are completely transparent.

Similarly, tokenization could also reduce the power of banks and governments.

Dependency on banks and governmental restrictions

In practice, removing the need for banks gives unbanked people access investment possibilities. Similarly, blockchains are regulatory-agnostic and thus based on their technical infrastructure not limited by any regulatory constraints (e.g. trading limitations or tax structures of a specific country). However, because citizens are bound to local laws are many jurisdictions require banking licenses, blockchain-based issuance/trading platforms might be possible technically but impossible by law.